CHESSNOID

I read an excellent interview of Princeton economist Paul Krugman about the state of the economy. I really agree with what he had to say. I know many banks, mortgage companies, and investment companies announce they are ahead of the curve and putting money in reserves to offset last quarters write offs or losses only to follow up with more news that they are doing the same thing for this quarter and next quarter with even greater write offs. Exactly how much bad loans were made. According to Krugman:

Fortune: By year-end, 15 million Americans could have mortgages worth more than the value of their homes. What happens then?

Krugman: Actually, I think home prices will fall enough for us to produce about 20 million people with negative equity. That’s almost a quarter of U.S. homes. If home prices are rising, or if there’s positive equity, you can refinance or sell. But if you have negative equity, you can end up being foreclosed on, and then some people will just find it to their advantage to walk away. We’re probably heading for $6 trillion or $7 trillion in capital losses in housing. Some fraction of that will fall on owners of mortgages. I still think the estimates people are putting out there – $400 billion or $500 billion in losses – are too low. I think there’ll be $1 trillion of losses on mortgage-backed securities showing up somewhere.

Based on how much these companies aggressively loaned out over the last 5-6 years, these numbers he suggest are probably the most accurate ones. Which means that these overvalued properties will continue to come down in line with incomes that are actually being made. In the past, there was always a rule of thumb that people would receive loans only 3 to 3 1/2 times their incomes and be required to put a 20% down payment. Both these basic rules that banks followed to keep the rate of losses were thrown out the last few years so they could cash in on the housing bubble charging fees left and right. They all made a killing those past few years. Now those bad decisions are coming back to haunt many of those companies. Recently, the federal reserve committed a moral hazard in bailing out Bear Stearns. They argue it would of collapsed the entire financial system. So the question is what will they do next when the next financial organization gets ready to fall apart. There are many more out there waiting to announce they are in a bad situation too, and will be happy to give up their company to someone else like the federal government to bail them out. By the way, the federal government’s funds inherently come from our tax money. Do we really want to save greedy companies who made bad decisions and failed to act within their fiduciary responsibility? Hell no!

As far as the federal government’s plan to bail out the economy by sending out refund checks, I think it is weak. Krugman says spend it on public infrastructure. This will create jobs and help strengthen the country at the same time. He puts it better:

What do you think about the government’s economic stimulus plan?

I wasn’t happy with it. Most of the money is given to people who are not much inclined to spend it, people who are not in financial difficulty. And therefore they will just put it in the bank or pay down credit card debt. I’ve been trying to make the case that since this thing is going to go on for a long time, effectiveness is more crucial than speed. I’m actually for public investment now – repairing bridges, building infrastructure. Normally people say if you try to do any public investment to stimulate the economy, the recession will be over before it can come online. But I don’t think that’s a problem this time.

I enjoyed his answers and if you want to read the whole interview just click this link:

How bad will credit crisis get? By Jia Lynn Yang